FX Watch – UK politics to hurt sterling

by: Georgette Boele , Nick Kounis

141201-UK-politics-to-hurt-GBP.pdf ()
  • Political uncertainty will weigh on sterling in the run-up to the election…
  • …reflecting the possibility of a hung parliament and uncertainty about the UK’s future in the EU
  • We also expect the Fed to raise rates before the BoE
  • We have added GBP short versus USD on our high conviction list
  • Our targets are 1.47 at the end of 2015 and 1.33 at the end of 2016

GBP to be affected by political uncertainty?

The debate about the UK’s future in the European Union could well heat up in the run-up to the elections in May. The dissolution of the parliament will be on 30 March 2015 and the election will be held on 7 May 2015. There is a possibility of a hung parliament. In addition, question marks about the UK’s future in the EU could create uncertainty for businesses about the outlook. This is particularly the case for companies that are based in the UK with an eye to accessing the single market and export-dependent businesses more generally. This political uncertainty in the run-up to the election could undermine investor sentiment towards the UK and sterling in particular. In this FX Watch we take a closer look at the political developments and their possible impact on sterling.

What does history tells us about hung parliaments?

In the last 100 years, the UK has experienced a hung parliament five times (1910, 1923, 1929, 1974 and 2010). It is increasingly likely that the 2015 elections will result in another hung parliament as the recent polls show that it will be a close call.  A hung parliament occurs when no single political party or a bloc of allied parties has an absolute majority of seats in the parliament. Do hung parliaments have impact on sterling? There are no financial market data available in the periods of hung parliaments in 1910, 1923 and 1929. However, we have data relating to the most recent cases and sterling weakened in both.

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In February 1974,  the Labour Party won the elections but failed to have an absolute majority. In the run-up to this election sterling was already under heavy pressure. From January 1970 to February 1974 sterling lost more than 16% on a trade weighted basis. Afterwards, this negative trend continued and sterling lost another 24% (see graph above). We doubt that the hung parliament was only responsible for this substantial slide in the value of the sterling, because more crucial events played out on a global level. For example, the first oil crisis in October 1973 to March 1974 pushed oil prices up from 3 USD per barrel to 12 USD per barrel. This had a substantial negative impact on the global economy, resulting in a period of high inflation and low global growth or so-called stagflation. The political uncertainty in the UK made things worse for sterling and thereby contributing to the slide in sterling.

The last time the UK had a hung parliament was at the previous elections in 2010. The Conservative Party won the largest numbers of votes and seats but fell twenty seats short. The coalition government that was subsequently quickly formed was the first coalition in British history. In the run-up to the election, sterling weakened up to March 2010 (see below). Afterwards, sterling recovered because political uncertainty in the eurozone was more substantial.

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Will the prospect of a new hung parliament hurt sterling?

It is likely that the possibility of a hung parliament will weigh on investor sentiment as the UK could struggle to form a new coalition government. The sharp divergence in the political establishment and among voters about the UK’s future in the European Union could also weigh on sentiment towards sterling and UK assets. The discussion will heat up in the run-up to the election.

Uncertainty about the UK’s future in the EU

The conservative party – currently the senior partner in the governing coalition – has promised an in-out referendum in 2017. Meanwhile, the UK independence party (UKIP), which has seen a sharp rise in popularity in the opinion polls over recent months, is pushing for an earlier vote. The UK Independence Party is a Eurosceptic political party. The Pro-European parties, such as the Labour Party and Liberal Democrat Party, may not have sufficient votes between them to form a government.

Impact of a possible EU referendum

We used behaviour in financial markets up to the Scottish referendum vote (18 September 2014) as a guide about how these markets could react if an EU referendum were to be held. Once again, sterling had the tendency to weaken in the period from July up to September when the Scottish independence vote came more into focus. However, this happened in a period that financial markets pushed out Bank of England rate hikes from this year to next year, following dovish comments from the BoE and lower inflation numbers. This is reflected by lower UK Gilt rates in the same period.

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What comes as a surprise is that the major UK stock exchange was not negatively affected by this Scottish independence vote. This signals that a sizeable part of sterling’s weakness during this period was linked to the downward adjustment in interest rate expectations. However, some of the decline in interest rate expectations also reflected fears that the economy might get hurt in the case of a Scottish yes-vote.

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An EU referendum vote has far more implications than a Scottish referendum vote in case the exit is favoured. A British exit from the EU (or Brexit) will likely harm the economy and sterling significantly. It could hurt:

  • Foreign direct investments (many companies invest in the UK to access the single market
  • Exports (EU by far the largest market for the UK)
  • UK domestic demand (due to uncertainty and the effects above)

The extent of the impact will depend on the agreement the UK comes to with the EU about the extent of access to EU markets. That is highly uncertain. However, direction is clear: negative for sterling.

Sterling short versus the US dollar on our high conviction list

We have decided to put sterling on our high conviction list as a short versus the US dollar at 1.5670. There are several reasons for this. For starters, sterling has the tendency to weaken in a period of political uncertainty. In addition, the US Federal Reserve will start hiking earlier than the Bank of England in our view. As a result of these forces we expect GBP/USD to weaken to 1.47 at the end of 2015 and 1.33 at the end of 2016